Chapter 5 Monetary Theory and Policy © 2001 South-Western College Publishing Company

2 Monetary Theories nDeveloped by John Keynes and his students 4Initially tried to explain inadequacy of monetary policy during great depression 4Effectiveness of monetary policy depends upon The sensitivity (elasticity) of economy to changes In interest rates 4Advocates fiscal policy

3 Monetary Theories nKeynesian theory continued 4Focus on how a government surplus or deficit can influence the economy 4Advocates proactive economic policy 4Can consider the theory using the framework of loanable funds

4 Monetary Theories nKeynesian theory to correct a weak economy 4To stimulate the economy the Fed buys securities in an open market operation 4Fed’s actions increase the supply of loanable funds 4Interest rates drop and business investment goes up nKeynesian theory to correct high inflation 4Government policy to reduce spending

5 Monetary Theories nKeynesian theory and credit crunches 4Banks’ willingness to lend affects monetary policy 4Banks lend based on evaluation of borrower’s ability to repay, not just availability of funds 4Monetary policy to stimulate the economy works only if banks find enough qualified borrowers 4Restrictive monetary policy may magnify credit crunch

6 Monetary Theories nQuantity theory 4Based on equation of exchange 4MV=P G Q nM = amount of money in the economy nV = velocity, average number of times each dollar changes hands during the year nP G = weighted average price level of goods and services in the economy nQ = quantity of goods and services sold

7 Monetary Theories nMonetarists 4Velocity is affected by Income levels Frequency income is received Use of credit cards Inflationary expectations 4Velocity changes found to be predictable and not related to fluctuations in money supply

8 Monetary Theories nMonetarist 4Let economic problems resolve themselves 4Low growth reduces borrowing and lowers interest rates 4Problem: takes time nKeynesian 4Need to take action to lower interest rates 4High money growth to fix a recession by lowering rates 4Problem: Might ignite inflation

9 Monetary Theories nMonetarist 4Low, stable growth in the money supply 4Focus on maintaining low inflation and will tolerate what they call natural unemployment nKeynesian 4Actively manage the money supply 4Willing to tolerate inflation that helps reduce unemployment

10 Tradeoff Faced By The Fed nGoals of the Fed 4Steady GDP growth 4Low unemployment 4Maintain low inflation nTradeoffs 4Lowering unemployment may put pressure on inflation 4Lowering inflation may increase unemployment

11 Tradeoff Faced By The Fed nTradeoffs between employment and inflation make it difficult to solve both problems simultaneously nImpact of other forces 4Factors outside the control of the Fed affect employment and inflation 4Classic example of the tradeoff is the summer of 1990 with Gulf War and high oil prices but signals pointing to a possible recession

12 Economic Indicators Monitored By The Fed nIndicators of economic growth 4Gross Domestic Product or GDP 4Industrial production 4National income 4Unemployment nIndicators of Inflation 4Producer price indexes 4Consumer price Indexes 4Other indicators

13 Integrating Monetary And Fiscal Policies nHistory 4Executive branch usually most concerned with employment and growth 4Fed and administration may differ on whether or not inflation or growth needs the most emphasis 4Agreement when inflation and unemployment are at relatively low levels

14 Integrating Monetary And Fiscal Policies nCombined monetary and fiscal policy effects 4Fiscal policy usually has a bigger influence on the demand for loanable funds 4Monetary policy usually has a bigger influence on the supply of loanable funds

15 Global Effects On Monetary Policy nImpact on the dollar 4Value of the dollar relative to other currencies can affect inflation 4For example, a weak dollar stimulates U.S. exports, discourages imports and stimulates the economy 4Fed less likely to stimulate the economy if the dollar is weak